Netflix-onomics

Netflix had a cracking line-up of new content last month — Season 2 of 13
Reasons Why, Season 5 of Arrested Development, and 4 stand-up specials,
amongst others. This year they plan to spend $8 billion on content, on-par with
media juggernauts like Time Warner (HBO) and Disney.

$8 billion is a lot of money. Where does it all go? Well, it turns out that hit
shows don’t come cheap:

These are non-trivial amounts of money. Are they actually worth it?

Season 1 of Stranger Things had a price tag of $50M. With Netflix making around
$100/year per subscriber, it would need to see 500,000 new signups to break
even. Given that 14 million people tuned in to Stranger Things in its first
month, it’s pretty plausible that ~5% of them were new users that subscribed
because of the show. Not only that, but a large chunk of Season 1 fans will have
renewed their subscriptions in anticipation of Season 2 — all-in-all, it was
probably worth a lot more than $50M to Netflix.

The maths works out nicely in this single case of one of Netflix’s most
successful shows, but do the numbers add up across the board?

Yes and no. In 2017 Netflix reported a profit of $500 million, but they had to
take on $2 billion in debt to make it happen.

Netflix has 3 categories of content:

Licensed, 2nd-run

Licensed, original

Self-produced, original

From 2007–2013, its streaming library consisted solely of licensed 2nd-run
content: movies and shows that have been out for a while but still have appeal —
Friends, The Office.

With the launch of House of Cards in 2013, Netflix starting exploring licensed
original content — “Netflix Originals” that are produced and owned by other
studios, but with Netflix having exclusive 1st-run distribution rights.

This proved successful, so the company took the plunge to started self-producing
original content — full vertical integration where Netflix owns everything from
production to release and beyond — with the release of Stranger Things in
2016.

These categories come with different economics for Netflix, and digging into
this, we can see why the company has burned through so much cash.

In a typical 2nd-run licensing deal, Netflix pays an annual fee in return for a
collection of movies or shows. In 2010, they signed a 5-year $200M/year deal to
acquire a library of around 2000 movies from Paramount, Lionsgate and MGM.
Netflix will have many of these deals active at any point in time, adding up to
a significant chunk of its content spend.

Deals for licensed originals often come with competition from traditional
networks. Netflix had to compete with HBO and AMC, amongst others, for House of
Cards, and won not just on price ($3-4M per episode) but also by making an
unprecedented 2-season commitment, without so much as a pilot to go on. Contrary
to the widely-propagated “data can read our minds now” narrative, this bet
wasn’t actually based much on viewership
data.

Other licensed original deals can be highly non-standard, and not the kind of
arrangement that traditional networks would consider. Netflix’s $200M deal with
Marvel for 60 episodes spread over 4 shows and a crossover
mini-series is one
such example. The partnership was unprecedented not for its price tag — a far
cry from Marvel’s Agents of S.H.I.E.L.D with its $14M pilot — but because it
gave Marvel the creative license to develop 5 interconnected shows together,
something difficult to pull-off with traditional networks.

Self-produced originals can be different still. There have been an array of
deals with individual showrunners, actors and writers to produce content
exclusively for Netflix, most notably producer Ryan Murphy’s $300M 5-year
contract, the biggest producing deal in TV history. A successful collaboration
with Netflix is often what sows the seeds for these elusive deals — Shawn Levy,
the Stranger Things producer who originally pitched the show, recently signed
a 4-year contract to develop TV projects exclusively for Netflix.

When it comes to movies, Netflix gets involved at all parts of the timeline,
picking up films like Bright for $90M pre-production, and others after
screenings at film festivals — Beasts of No Nation, $12M.

The economics behind movies are very different to TV, and make Netflix’s
proposition interesting for studios. A film typically gets acquired by a
distributor (e.g. Fox Searchlight) for a lump sum, who license it to movie
theatres in the first instance, from which the film receives a share of
box-office revenue, known as “backend”. The up-front payment from the
distributor usually covers production costs and some pocket money for the
studio, but it’s the backend that gives the film a shot at the big bucks.

Hollywood is governed by power-law returns – something close to 50% of films
end up making a
loss, with the top
6% of films accounting for half of all film profits, and the majority of that
coming from the backend. Netflix’s generous lump-sum acquisitions — 200% of the
film’s budget for Beasts of No Nation — bring to the table guaranteed profit
and a tidy payout, but don’t come with the backend lottery ticket, a
deal-breaker for some.

How do these different models affect Netflix’s bank balance?

Licensed 2nd-run content, for Netflix, is like leasing a car — you don’t have to
pay a tonne of money up-front, but instead pay a little bit every year to keep
using it. The downside is that it’s never really yours so you have to use it
carefully. In Netflix’s case, this often means not being able to show some
content outside of the US.

Original content is more like buying a car — you pay a lot up-front, perhaps by
borrowing a bit from your parents, but the car is yours — you can take it
anywhere, and can use it for as long as you want at no extra cost.

Netflix is aiming for 50% of its content library to be original content, which
comes at an upfront cost of many billions of dollars. This isn’t too worrying
— many worthwhile projects have the model of “high initial cost with cheap,
long-lasting utility” — factories, railroads, housing. To account for this,
there are 2 different ways to consider “how much money a company has”: net
income (profit) and free cash flow.

When reporting profit, companies can amortise (spread out) their large upfront
investments to reflect that their payoff is going to be over a period of many
years. With our Stranger Things example, Netflix might amortise the cost like
so:

Year 1: 50% — $25M

Year 2: 30% — $15M

Year 3: 10% — $5M

Year 4: 10% — $5M

This would be on the basis that the company expect to harvest 50% of Stranger
Things’ value in its 1st year, 30% in its 2nd year, and so on.

Free cash flow, however, is closer to “money received minus money spent”, and
shows that Netflix are currently spending a lot more than they make, funded by
large amounts of debt.

This is par for the course — the economy runs in large part because people are
able to spend money they don’t have, but the question is whether Netflix’s
investments will help it grow sufficiently to be able to settle its debts
further down the line.

Netflix is forecasting free cash flow of negative $3 billion-$4 billion in 2018. And the stock still soared? WTF?!?!?!